Rating action

Scope Ratings GmbH (Scope) has today taken the following rating actions on Santander UK plc’s synthetic securitisation tranches and credit-linked notes (CLNs):

Tranche A, GBP 1,606,110,000 (78.50%): assigned new rating AAA_SF

Tranche B, GBP 81,840,000 (4.00%): assigned new rating AA+_SF

Tranche C, GBP 81,840,000 (4.00%): assigned new rating A+_SF

Tranche D, GBP 51,110,000 (2.50%): assigned new rating A-_SF

Tranche E, GBP 112,500,000 (5.50%): assigned new rating BBB-_SF

Tranche F, GBP 81,900,000 (4.00%): not rated

Tranche G, GBP 30,700,000 (1.50%): not rated

Class E1 CLN, GBP 69,000,000 (3.37%): assigned new rating BBB-_SF

Class E2 CLN, GBP 43,500,000 (2.13%): assigned new rating BBB-_SF

Class F1 CLN, GBP 50,300,000 (2.46%): not rated

Class F2 CLN, GBP 31,600,000 (1.54%): not rated

The ratings assigned by Scope to the synthetic tranches A to E reflect the risk of losses with respect to a credit event under the final terms of the CLNs. The ratings on the synthetic tranches do not address potential losses resulting from the transaction’s early termination, any market risk, nor any counterparty risk associated with the transaction.

The ratings assigned by Scope to the CLN classes E1 and E2 reflect the expected loss associated with the payments contractually promised by an instrument on a particular payment date or by its legal maturity.

Scope did not assign ratings to tranches F and G nor to CLN classes F1 and F2. The scheduled redemption date of the CLNs is 22 April 2033.

Transaction overview

The Synthetic Securitisation Credit Linked Note Issuance Programme is a synthetic securitisation of a static portfolio of corporate loans granted to small and medium-size enterprises (SMEs) and commercial real estate (CRE) loans in the United Kingdom. Scope has rated the risk of losses on the synthetic tranches with respect to a credit event under the final terms of the CLNs. The reference portfolio is static and comprises 1,040 reference obligations, most of which are term loans (around 89%) with the remainder being revolving credit facilities (around 11%). Of the 1,040 exposures, 819 exposures or 72% of the pool are term loans and revolving credit facilities which are collateralised against CRE. Out of the 819 exposures, 571 are SME term loans and revolving credit facilities collateralised by CRE and the rest was underwritten internally by Santander UK as CRE exposures. The remaining 28% of the pool was provided to SMEs and corporate debtors.

The reference obligations are mostly denominated in British pound (97.3%), with the rest in US dollar or euro. The portfolio is short-seasoned: about 90% was originated from 2019 and around 70% from 2021. Roughly 87% of the reference obligations are scheduled for repayment before 2028, which corresponds to a pool weighted average life of 2.6 years. The composition of the reference obligations pool is consistent with Santander UK’s focus on short- to medium-term lending to SMEs and corporates and CRE loans. The largest industry concentration is real estate (41.5%) since about half of the pool consists of CRE loans, followed by financial and insurance (13.0%) and construction (7.3%). The rest of the portfolio is spread over more than 10 industries.

Scope received from Santander UK the performance data from the last five years for UK SMEs, corporates and CRE loans. The reference portfolio exhibits an average one-year economic capital probability of default of 1.49% based on Santander UK's internal risk assessment. However, as the historical data series does not encompass a complete economic cycle, Scope refrained from relying solely on this data to formulate default rate assumptions, instead applying specific stress scenarios to the one-year economic capital probability of default (see Quantitative Analysis section below).

Scope has assessed the portfolio's granularity by determining its 'effective' number, computed as the reciprocal of the Herfindahl index. Notably, the 10 largest borrower groups collectively represent just 5.0% of the portfolio, and individual group exposures are limited to 0.5% of the reference portfolio. This granularity bolsters the stability of Scope’s lifetime default rate assumptions. The limited effective number of industries is only 4.7, primarily resulting from the significant portion of CRE exposures, whose associated risks are mitigated to some extent by Scope’s relatively high recovery rate assumptions.

Under this transaction, Santander UK determines the losses on the reference tranches of defaulted assets in line with its internal loss calculation. The amount of loss is then adjusted for the actual loss during a maximum work-out period of 24 months. Losses are allocated to the respective synthetic tranches in reverse order of seniority, i.e. from tranches G to A. Each tranche and class of CLNs will be written down in line with the losses charged against the respective tranche.

The CLNs’ final terms define a credit event as: i) a failure to pay with respect to the reference obligation; ii) a bankruptcy of the obligor; or iii) a loss from the restructuring of a reference obligation. The final terms confer substantial supervisory authority upon the external verification agent, a reputable global accounting firm, which is responsible for validating all loss claims and ensuring that the assessments of expected loss and final loss align with Santander UK's internal protocols. It is worth noting that the verification process is confined to each defaulted case, reflecting the thoroughness and scrutiny compared to the sampling method.

Rating rationale

The ratings reflect the legal and financial structure of the transaction as defined under the final terms of the CLNs; the credit quality of the underlying portfolio in the context of macroeconomic conditions in the UK; the ability and incentives of Santander UK as originator and servicer of the reference loans; and the supervision by the verification agent.

The ratings account for the respective credit enhancement of the tranches and the pro-rata release of risk coverage reflecting the reference portfolio amortisation, contingent on several portfolio performance triggers. The ratings also reflect the credit risk of the static reference portfolio, characterised by a limited lifetime default risk and a substantial recovery rate upon default for secured loans. The ratings incorporate the sensitivity of the tranches to changes in analytical assumptions.

The counterparty risk exposure of the CLNs to Santander UK as payer of the coupon and holder of the collateral account was also a factor in the ratings. In accordance with our Counterparty Risk Methodology, we have classified the transaction's exposure to Santander UK as 'excessive', as it plays several key transaction roles. Accordingly, CLN classes E1 and E2 credit-linked notes are currently capped at A+_SF.

Key rating drivers

Experienced CRE lender with prudent underwriting (positive)^1,2. Santander UK’s real estate lending dates back to 1944, with roots tracing back to the Abbey National Building Society's inception in the same year. It has evolved and expanded over the years and became a wholly owned subsidiary of the Santander Group in 2004 and was renamed Santander UK plc. The lender consistently applies conservative underwriting criteria. As an example, the weighted average current loan-to-value of the CRE loans is only 40.5%.

Static and granular portfolio (positive)². The portfolio includes 369 effective exposures across 314 effective borrower groups. The 10 largest borrower groups collectively represent 5% of the portfolio, with individual group exposures capped at 0.5% of the reference notional amount. This granularity enhances the stability of Scope’s lifetime default rate assumptions.

Pro-rata structure among senior credit protections (negative)¹. Tranches A to F are subject to pro-rata amortisation contingent on performance and concentration triggers. Upon the activation of these thresholds, amortisation transitions to being strictly sequential. This mechanism may result in a reduction of strength for tranches A to F.

Weakening UK macroeconomic outlook (negative)³. In the current economic environment, Scope recognises the less favourable short-term outlook for UK corporates as reflected in refinancing, default and recovery rates. Immediate challenges include the levels of accumulated debt, elevated running costs and tightening credit standards amidst rising interest rates.

Susceptibility of mezzanine tranches (negative)¹. The modelling outputs of tranches B to F show significant volatility in some of the major sensitivity scenarios tested by Scope.

Rating-change drivers

Positive. Increased credit enhancement from pool deleveraging along with lower default rates or higher recovery rates than expected may lead to upgrades.

Negative. Worse-than-expected refinance, default and recovery performance of the assets may result in downgrades.

Quantitative analysis and assumptions

Scope has used a concentrated-portfolio approach and analysed the portfolio on a loan-by-loan basis using a Monte Carlo simulation with a Gaussian-copula dependency framework. For each loan, Scope assumed: i) a specific default probability, commensurate with the loan’s weighted average life; ii) a specific recovery upon default; and iii) asset correlations between the loans. The resulting rating-conditional loss distribution and default timing were then used to project tranche losses, reflecting the loss-allocation mechanisms as well as the credit enhancement of the respective tranche.

Scope derived loan-by-loan probabilities of default from different sources such as Santander UK’s one-year economic probability of default, vintage data for defaults and market-wide data regarding corporate insolvencies and write-offs in the UK. The derived probabilities of default were adjusted based on qualitative aspects collected during Scope’s due diligence of Santander UK’s risk systems and processes.

Scope has derived for the reference portfolio an average default probability of 5.8% for a weighted average life of 3.0 years, with an implicit coefficient of variation of 81.1%.

Recovery rate assumptions were based on a target rating and whether the loan is secured or unsecured (‘secured’ if collateralised by real estate properties):

• Unsecured: 40.0% for B, 38.4% for BB, 34.4% for BBB, 31.6% for A, 25.6% for AA, and 20.8% for AAA.
   
• Secured: 94.5% for B, 93.9% for BB, 92.7% for BBB, 90.8% for A, 85.6% for AA, and 75.5% for AAA.

The resulting recovery rates at aggregated portfolio level are 76.1% at the B rating category and 55.0% at the AAA rating category.

Scope has applied a correlation framework which is appropriate for transactions involving multi-sector and multi-region assets. The maximum correlation can be split into: 2% for all loans; 5% for asset pairs sharing the same country; 10% for pairs sharing the same region; and 20% for pairs sharing the same sector.

Scope applied further recovery and correlation stresses to the exposures belonging to the top five borrower groups, i.e. an additional 10% haircut to rating-conditional recovery rates and an additional pair-wise correlation of 20%.

Sensitivity analysis

Scope tested the resilience of the credit rating against deviations in the main input parameters: the portfolio mean default rate and the portfolio recovery rate. This analysis has the sole purpose of illustrating the sensitivity of the credit rating to input assumptions and is not indicative of expected or likely scenarios. The following shows how the results for each rated tranche and each CLN change compared to the assigned ratings when the assumed portfolio default probability increases by 50% or the portfolio’s expected recovery rate reduces by 50%, respectively:

• Tranche A: sensitivity to default probability, zero notches; sensitivity to recovery rates, one notch;
   
• Tranche B: sensitivity to default probability, zero notches; sensitivity to recovery rates, five notches;
   
• Tranche C: sensitivity to default probability, zero notches; sensitivity to recovery rates, five notches;
   
• Tranche D: sensitivity to default probability, zero notches; sensitivity to recovery rates, five notches;
   
• Tranche E: sensitivity to default probability, zero notches; sensitivity to recovery rates, three notches;
   
• Class E1 CLN: sensitivity to default probability, zero notches; sensitivity to recovery rates, two notches;
   
• Class E2 CLN: sensitivity to default probability, zero notches; sensitivity to recovery rates, three notches.

Rating driver references
1. Transaction documentation and supporting material (Confidential)
2.  Loan-by-loan data tape of the reference portfolio (Confidential)
3. Scope has completed a monitoring review of the United Kingdom

Stress testing
Stress testing was considered in the quantitative analysis by considering scenarios that stress factors, like defaults and Credit-Rating-adjusted recoveries, contributing to sensitivity of Credit Ratings and consider the likelihood of severe collateral losses or impaired cash flows. The impact on the rated instruments is weighted by the assumptions of the likelihood of the events in such scenarios occurring.

Cash flow analysis
Scope Ratings primarily analysed the distribution of portfolio losses and its impact on the rated instruments, with the use of Scope Ratings’ Portfolio Model Version 1.1.
Scope Ratings performed a cash flow analysis of the transaction with the use of Scope Ratings’ Cash Flow Structured Finance Expected Loss Model Version 1.1, incorporating relevant asset assumptions, and taking into account the transaction’s main structural features, such as the instruments’ priority of payments, the instruments’ size and coupons. The outcome of the analysis is an expected loss rate and an expected weighted average life for the instruments based on the generated cash flows.

Methodology
The methodologies used for these Credit Ratings, (General Structured Finance Rating Methodology, 25 January 2023; Counterparty Risk Methodology, 13 July 2023; SME ABS Rating Methodology, 16 May 2023), are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The models used for these Credit Ratings are (Portfolio Model Version 1.1, Cash Flow Structured Finance Expected Loss Model Version 1.1), available in Scope Ratings’ list of models, published under https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity, the Rated Entities’ Related Third Parties, third parties and Scope Ratings’ internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Scope Ratings has not received a third-party asset audit. Scope Ratings has performed its own analysis of the data quality, based on information received from the Rated Entity or Related Third Parties, which is not and should be not deemed equivalent to the performance of due diligence or an audit. The internal analysis was considered when preparing the Credit Ratings and it has no impact on the Credit Ratings.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and the principal grounds on which the Credit Ratings are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings are UK-endorsed.
Lead analyst: Guang Yang, Analyst
Person responsible for approval of the Credit Ratings: Antonio Casado, Executive Director
The Credit Ratings were first released by Scope Ratings on 29 September 2023.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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